Elasticity and its implications

Lecture 2 – academic year 2015/16Introduction to Economics

Dimitri Paolini

Where we are…

• Lect. 1: Demand and supply• Lect. 1: Market equilibrium• Lect. 1: Market adjustment processes• Lect. 2: Elasticity

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What do we do today?

• The concept of elasticity• The elasticity of demand with respect to prices• Elasticity and total revenue• Elasticity of demand with respect to income• Elasticity of supply with respect to prices• Examples

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Elasticity

It measures the sensibility of buyers and sellers to variations in the market conditions.

It allows one to study demand and supply with greater precision.

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Three types of elasticity

• Elasticity of demand with respect to prices

• Elasticity of demand with respect to income

• Elasticity of supply with respect to prices

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Elasticity of demand with respect to prices

The elasticity of demand with respect to prices ED(p) measures how the quantity demanded respond to variations in market prices.

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Elastic and inelastic demand

Inelastic demand•The quantity demanded does not significantly react to variations in market prices

Elastic demand•The quantity demanded significantly react to variations in market prices

Limit cases: perfectly inelastic, elastic and unitary.

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Perfectly inelastic demand

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5

4

Demand

Quantity1000

2. …leaves the quantity demanded unaltered .

Price

1. An increase in price...

Perfectly elastic demand

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4

Quantity0

Demand

2. When the price is equal to 4 euro consumers are available to buy any quantity

Price1. For any price greater than 4 euro the quantity demanded in null

3. For any price smaller than 4 euro the quantity demanded in infinite

Demand with unitary elasticity

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5

4Demand

Quantity1000 75

1. A 25% increase in price...

Price

2. …causes a 25% reduction in the quantity demanded

Elastic demand

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5

4 Demand

Quantity1000

Price

50

2. …causes a 50% decrease in the quantity demanded

1. A 25% increase in price...

Inelastic demand

12

5

4 Demand

Quantity1000

Price

90

2. …causes a 10% decrease in the quantity demanded

1. A 25% increase in price...

When is ED(p) high?

Demand tends to be elastic.... for luxury goods .. in the long period.. in general, for goods that have close

substitutes.

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When is ED(p) low?

• Demand tends to be inelastic...… for primary goods… in the short period… in general, for goods that have no substitutes

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Low elasticity: Oil

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How to compute ED(p)

ED(p) is computed as the ratio between the percentage variation in the quantity demanded and the percentage variation in price.

ED(p) = – [Δ q / q0] / [Δ p / p0] =

= – [(q1 – q0) / q0] / [(p1 – p0) / p0]

Notice: ED(p) is a positive number.16

How to compute ED(p)

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5

4 Demand

Quantity1000

Price

50

How to compute ED(p)

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5

4 Demand

Quantity1000

Price

50

Demand is elastic with respect to price

Elasticity and total revenue

Total revenue is the total expenses of consumers and the total proceeds for producers

It is computed as the product of price and quantity sold

TR = p X q

Total revenue varies along the demand curve depending on the degree of elasticity.

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Elasticity and total revenue

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4

Demand

Quantity

P

0

Price

P · Q = 400(Total revenue)

100

Q

Elasticity and total revenue

If the demand is elastic, an in price (more than proportional decrease) in the quantity demanded: total revenue

If the demand is inelastic, an in price (less than proportional decrease) in the quantity demanded: total revenue

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Elasticity and total revenueExample: Inelastic demand

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3

Quantity0

Price

80

Revenue = 240

Demand 1

Demand

Quantity0

Revenue = 100

100

Price

1

100

Elasticity of demand with respect to income

• The elasticity of demand with respect to income ED(Y) measures how the quantity demanded respond to changes in income

• It is computed as the ratio between the percentage variation in the quantity demanded and the percentage variation in income

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How to compute ED(Y)

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When is ED(Y) low?

When the good is necessary, such as clothes, food, fuel, drugs, but also cigarettes for a heavy smoker

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When is ED(R) high?

When the good is luxury, such as sport cars, caviar, fur coat, etc.

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Cross elasticity of demand

The cross elasticity of demand with respect to price E(p) measures the responsiveness of the demand for a good to a change in the price of another good.

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We can consider two goods, such as sugar (S) and coffee (C) :

Cross elasticity of demand

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• Complementary goods (coffee and sugar): cross elasticity with negative sign: as the price of coffee rises, the demand for sugar falls.

• Substitute goods (tea and coffee): cross elasticity with positive sign: as the price of tea rises, the demand for coffee rises.

Cross elasticity of demand

Elasticity of supply with respect to price

Elasticity of supply with respect to price ES(p) is measured as the ratio between the percentage change in the quantity supplied and the percentage change in price.

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Values of ES(p)

• Perfectly elastic ES(p) =∞

• Elastic ES(p) >1

• Unitary elasticity ES(p) =1

• Inelastic ES(p) <1

• Perfectly inelastic ES(p) =0

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Perfectly inelastic supply

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5

4

Supply

Quantity1000

2. …leaves the quantity supplied unaltered.

Price

1. An increase in price…

Perfectly elastic supply

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4

Quantity0

Offerta

2. At the price of 4 euro sellers are willing to sell any quantity.

1.For any price greater than 4 euro the quantity supplied is infinite

3. For any price greater than 4 euro the quantity supplied is null

Price

When is ES(p) high?

• When producers enjoy some flexibility in the use of resources:– Residential zonings close to the sea have low

elasticity of supply;– Books, cars, TVs, have high elasticity of supply.

• In the long-run.

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Elasticity of demand: An application

• Ascertain whether the demand curve or the supply curve shifts.

• In which direction? • Draw the S-D graph to see how the market

equilibrium and total revenue change.

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Elasticity of demand: An application

• Can good news for agriculture be bad news for farmers?

• What does it happen to a wheat farmer and to the wheat market if some university researchers discover a new variety of wheat that is more productive than the varieties presently available?

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An increase of supply in the market for wheat

• Check whether the event affects both supply and demand.

• Ascertain the directions of the shifts• Draw the supply-demand graph to identify the

new market equilibrium

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3

Quantity of wheat1000

Price of wheat

Demand

S1

An increase of supply in the market for wheat

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3

Quantity of wheat1000

Price of wheat

Demand

S1

An increase of supply in the market for wheat

1. If the demand is inelastic an increase of supply…

2

110

S2

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3

Quantity of wheat1000

Price of wheat

Demand

S1

An increase of supply in the market for wheat

2

110

S2

2. …causes a significant drop in price...

1. If the demand is inelastic an increase of supply…

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3

Quantity of wheat1000

Price of wheat

Demand

S1

An increase of supply in the market for wheat

1. If the demand is inelastic an increase of supply…

2

110

S2

2. …causes a significant drop in price...

3. … and a less than proportional increase in the quantity sold. As a consequence the total revenue falls (from 300 to 220 €).

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TR1= 3·100= 300

3

1000

2

110 Quantity of wheat

Price of wheat

Demand

S1 S2

An increase of supply in the market for wheat

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TR2= 2·110= 220

3

1000

2

110 Quantity of wheat

Price of wheat

Demand

S1 S2

An increase of supply in the market for wheat

Conclusion

• The elasticity of demand with respect to price measures the responsiveness of demand to price changes

• If the demand is elastic, an increase in price causes a reduction in total revenue

• If the demand is inelastic, the total revenue increases as the price rises

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Conclusion

• The elasticity of supply with respect to price measures the responsiveness of supply to price changes

• Usually, both demand and supply are more elastic in the long-run than in the short-run

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Next week

Demand, supply and elasticity: applications and exercises

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